When it Comes to Recession and Deflation, the Fed is the Last to Know

When it Comes to Recession and Deflation, the Fed is the Last to Know

The Federal Reserve uses a complicated econometric model to make its forecasts about the U.S. economy. This model is called “Federal Reserve Bank U.S.,” nicknamed FERBUS. It shows growth of 5% in the near future.

But markets are telling another story of economic weakness. Markets are also signaling only a 35% chance of a rate hike in September 2015 even as Janet Yellen keeps saying she plans to raise rates. Maybe it’s time the Fed stopped listening to Ferbus and started focusing on markets.

The Federal Reserve keeps forecasting a rosy scenario with 5% unemployment, 2.5% growth and 2% inflation. Yet the Fed has the worst forecasting record of any major institution.

Their forecasts have been consistently wrong by orders of magnitude for six years. Actual data show unemployment higher, growth lower and inflation lower than the Fed expects.

Deflation is the Fed’s worst nightmare. The problem with deflation is that it is not just a transient drop in prices. Deflation tends to feed on itself and becomes impossible to stop. Lower prices cause consumers to delay purchases, which causes even lower prices as merchants try to clear the shelves.

New orders dwindle, inventories collapse and layoffs begin. Asset sales beget more asset sales, with lower prices causing financial distress and a wave of loan defaults. Commodities prices are telling us that a dangerous new wave of deflation has begun.

What happens if the Fed raises rates at exactly the wrong time based on a faulty forecast? It will cause a recession and the collapse of asset bubbles.